Now that we've studied the money supply process, we take a closer
look at how the Fed impacts the domestic economy. The Fed has three
tools at it's disposal to impact the money supply: (1) open market
operations (the federal funds rate target), (2) discount lending, (3)
the reserve requirement. In this chapter we see how each tool impacts
the federal funds market and evaluate its usefulness.

The Market for Reserves and the Federal Funds Rate

Recall that the federal funds rate is the short term interest rate
for the interbank lending market where banks lend reserves to each
other. The Fed conducts monetary policy primarily through affecting
this market, which in turn impacts other debt markets and the economy.

The figure below shows the market for reserves, which determines the equilibrium federal funds rate:

Note that the demand for reserves is downward sloping with respect
to the federal funds rate. This is because the federal funds rate is
the opportunity cost for a bank holding excess reserves, since the bank
could lend out those reserves at the federal funds rate. So the higher
the federal funds rate, the higher the opportunity cost of holding
excess reserves, so the quantity of excess reserves (and reserves) will
be lower.

The supply curve is upward sloping because as the federal funds
rates rises, banks will provide more reserves for other banks to borrow.

How do the three tools of monetary policy impact this market?

We have seen in chapter 17 how an open market purchases increases reserves in the banking system. So
an open market purchase increases the supply of reserves, causing the
federal funds rate to fall. An open market sale causes the federal
funds rate to rise.

We have seen in chapter 17 how increases in discount loans will increase reserves. So a lower discount rate will encourage bank borrowing, increasing the supply of reserves and decreasing the federal funds rate.

With an increase in the required reserve ratio, banks must hold more reserves. A higher reserve requirement increases the demand for reserves and causes the federal funds rate to rise.

Open Market Operations

Open market operations are the most important tool of monetary
policy. An open market purchase increases the monetary base and the
money supply, lowering short-term interest rates. In theory the Fed
could conduct open market operations with any type of debt security. In
reality it uses Treasury securities because this market is large and
liquid, so it can absorb large transactions.

The FOMC votes on open market operations by voting on a federal
funds rate target to be acheived through open market operations. The
actual buying and selling is left to the Federal Reserve Bank of New
York (which is why the FRBNY president always has a vote on the FOMC).
Every trading day, the FRBNY open market operations staff surveys
conditions in financial markets to determine what type and how much of
open market operations are need. They then line up potential buyers and
sellers of Treasury securities by getting price quotes from large
dealers in securities known as primary dealers. There are about 30
primary dealers. (FYI: Cantor Fitzgerald, a bond trading firm that lost
658 people in the WTC attack in September, did almost 25% of the
trading volume in Treasury securities. They have since recovered that
market share.) Trades are executed throughout the day, while watching
for the desired impact in the federal funds market.

Now the FOMC can set a target and the FRBNY buys and sells to keep
the equilibrium federal funds rate as close to the target as possible.
The difference between the target and actuall federal funds rate is
shown in figure 18.2, page 464.

OMO are the primary tool of monetary policy. They are
flexible, so the Fed and change the federal funds rate by a little or a
lot. They are quick and precises, with same day impact on the
interbank lending market, with other short-term interest rates
following quickly. They are reversible. If the Fed buys too
many securities, they can turn around and sell some of them.

Discount Lending

Discount loans increase the monetary base and money supply. Each
Federal Reserve district bank has a discount window where loans are
made. They affect the volume of discount loans by setting the discount
rate and by deciding when to make loans.

Discount loans are made to banks for very short-term liqudity
problems at the primary discount rate = federal funds rate + 100 basis
points. They are also given to banks in regions with seasonal
fluctuations in reserves (such as agricultural areas), and finally to
banks in serious trouble at the secondary discount rate = federal funds
rate + 50 basis points. However, banks have an incentive not to come to
the discount window too often, since this would invite additional
scutiny from regulators concerned about the bank's liquidity management.

Beyond their ability to affect the monetary base, discount loans get to the original purpose of the Fed: To be a lender of last resort
to banks in trouble in order to prevent larger bank and financial
panics. The Fed, frankly, messed up this role during the Great
Depression, but have done well in the post-WWII period in its role as
lender of last resort. Even with the FDIC to insure deposits, the Fed
still needs to be willing to provide liquidity to protect large
depositors and to keep the FDIC from going bankrupt in the case of too
many bank failures.

Despite the importance of discount loans for financial market
stability, they are not an ideal tool for changing the money supply:

Changes in the discount rate may be taken as a signal of monetary policy (an announcement effect)
when the Fed is only trying to keep up with market interest rates. The
fluctuating spread between the federal funds rate and discount rate
will cause the volume of discount loans and the money supply to
fluctuate, actually making it harder to control the money supply.

Discount loans are not completely under Fed control. They depend on bank behavior as well.

Discount rate changes are not easily reversible, since the rates on previous loans cannot be changed.

Reserve Requirements

The Federal Reserve Board of Governors sets the reserve requirements
for depository institutions. Higher reserve requirements reduce the
money multiplier and the money supply, causing short-term interest
rates to rise. Required reserves on checkable deposits are 3% up to
$44.3 million and 10% on the amount over $44.3 million.

Changing the reserve requirement is certainly effective. In fact it
is a very powerful tool. This is actually a disadvantage. The Fed
usually wants to make small adjustments to the money supply, and that
is not possible with the reserve requirment. As one of my economics
professors once said, "it's like using a nuclear warhead when just a
fly swatter will do."

Also, practically speaking, the reserve requirement is expensive to
change: Banks must change all types of liquidity and asset management
strategies. Frequent changes in the reserve requirement would force
banks to hold a large cushion of excess reserves to deal with the
resulting uncertainty, cutting into their profits.

While reserves were originally required to ensure the soundness of
the banking system in meeting depositor withdrawals, today the reserves
deposited at the Fed help the Fed maintain the federal funds rate
target.

The Goals of Monetary Policy

There are 4 basic goals of monetary policy , which are really desirable goals we want to see for the economy:

High Employment (Low unemployment). The federal government
is required under laws passed in 1946 and 1978 to promote high
employment consistent with price stability. It is clear why high
unemployment would be bad: unused resources mean lost output and there
are huge personal/social costs as well. But what level of unemployment
is acceptable? As we learned in Principles of Macroeconomics the goal
for unemployment is NOT zero. There will always be frictional and
structural unemployment. The goal for unemployment is the natural rate of unemployment,
estimated to be somewhere between 4 and 5%. The current unemployment
rate is around 5.1%. FYI: The unemployment rate for the
Syracuse area is currently at 4%, lower than the NYS 4.6%.

Economic Growth. This goal is closely related to the goal
of high employment since strong economic growth leads to job creation
and high employment while stagnant or falling economic growth means
layoffs. Economic growth (the % change in real GDP) in the U.S.
averages about 3%, although the averages for growth in the 1970s and
1980s were lower, but have rebounded in the 1990s. In 2006 real GDP
rose about 2.7%.

Price Stability (Low inflation). Today this is view as the
most important goal of monetary policy, not only by the Fed but by the
European central banks as well. At high levels, inflation creates
uncertainty, lower investments, and lower economic growth. How high is
too high? In the U.S. currently, the Fed wants an inflation rate of
about 2%, with higher than 4% being unacceptable. Inflation is a
concern in 2007, given rising energy and food prices. In 2006 prices
rose about 2.5% as measured by the CPI.

Financial Market Stability. This category includes the
stability of financial institutions, interest rates, and foreign
exchange rates. Interest rate stability creates a more favorable
investment climate and promotes economic growth. Stepping in to avoid
financial crises also avoids the extreme recessions that can follow
such crises. A stable exchange rate promotes international trade. This
last goal often requires international cooperation with many central
banks around the world.

These criteria rule out discount lending and reserve requirement, and leave open market operations. Why?

The Fed has complete control over open market operations. Not true with discount loans, where the banks decide to borrow or not.

Open market operations are flexible. They can do a little or a lot, depending on the size of the change desired.

Open market operations are easily reversible. If the initial purchase is too large, then the Fed just has to sell some.

Open market operations are quick. Trades and their impact appear almost immediately during the trading day.

To summarize, all 3 tools at the Fed's disposal are capable of
changing the money supply and interest rates, but only one tool, open
market operations, is of practical use for conducting monetary policy.
We will see how this tool is used to achieve economic goals

The Fed has these ultimate goals, but they only have direct control
over a open market operations. Unfortunately it can take over a year
for the tools to eventually impact the economic goals. How does the Fed
gauge its progress? Through the use of targets. These targets are other
variables related to both the tools and the goals of monetary policy.
By looking at these variables, the Fed knows if it is on the right
track.

The process looks like this:

First, the operating targets are variables closely related to the
tools, and respond immediately to changes in the tools. Possible
operating targets include reserves, the federal funds rate, or a Tbill
rate. Currently the FOMC targets the federal funds rate.

The intermediate targets are variables affected by the operating
target, but are closely associated with the goals. Possibilities
includes the money aggregates (M1, M2, M3) or other short-term and
long-term interest rates in the economy. Given the breakdown between
monetary targets and the economy is recent decades, intermediate
targets are not as important as they used to be.

So for example, the Fed may want a 5% growth rate for nominal GDP.
To do this, they believe they need 4% growth in M2, which will be
accomplished with 3% growth in the monetary base. Then, the Fed
conducts open market purchases to increase the monetary base by 3% (the
operating target), which is measures fairly quickly. Over the next few
months it follows changes in M2 to hit a growth rate of 4%. If M2
growth is too low, the Fed will conduct more open market purchases. If
the growth rate is too high the Fed will reverse and conduct open
market sales.

However, the FOMC MUST make a choice between monetary and interest
rates targets: they cannot simultaneously target both! Let's see why.

Suppose the Fed wants to target the money supply M*. As money demand
fluctuates, the equilibrium interest rate will change. This is because
the Fed is committed to M* as a target so it does not shift the MS
curve when MD shifts. The result is an interest rates that fluctuates
with money demand:

Suppose instead the Fed wants to target an interest rate i*. As
money demand fluctuates, the equilibrium interest rate will rise above
or fall below i*, the target. To prevent this, the Fed must increase or
decrease the money supply to compensate, keep the equilibrium interest
rate at i*. The result is that the money supply fluctuates when money
demand fluctuates as the Fed pursues its interest rate target.

If the Fed targets the money supply, then it loses control of
interest rates. If the Fed targets interest rates, then it loses
control of the money supply.

The Taylor Rule

The federal funds rate is clearly a popular target for monetary policy. How should this target be chosen?

The Taylor Ruleis currently a popular policy rule
created by John Taylor of Stanford University. The Taylor rule is an
equation the says the target federal funds rate should be based on the
current inflation rate, the real federal funds rate (a long-run
equilibrium rate), the gap between real GDP and full employment GDP,
and the gap between actual inflation and the inflation target.

So when inflation rises above its target level, the federal funds
rate target should rise. When output falls below its potential level
then the federal funds rate target will be lower. So the rule responds
to economic conditions, including both prices and output. This
relationship makes the federal fund rate target based on concerns about
both price stability and the business cycle.

Figure 18.6 plots the FOMC's actual federal funds rate target
against the rate under the Taylor rule. There is a close correspondence
between the two. While the rule is a helpful guide, keep in mind that
discretion is also important for the unexpected, such as 9/11.